Online peer-to-peer (P2P) lending is emerging as a provider of credit to individuals as well as small businesses, with the potential to benefit borrowers (by reducing the high cost of bank credit, credit card debt and payday loans) and lenders (by providing opportunities to earn higher yields).

A significant hurdle for investors, however, is the information asymmetry between the borrower and the lender. The lender does not know the borrower’s credibility as well as the reverse. Such information asymmetry can result in adverse selection.

Financial intermediaries have begun to replace individuals as the lenders, buying loans from originators such as the Lending Club, Prosper, Square and SoFi, and creating investment products such as closed-end “interval” funds that individual investors can use to access the market. These funds are not mutual funds, because they don’t provide daily liquidity. Instead, they provide for redemptions (with limits) at regular intervals (such as quarterly).

Reducing Asymmetric Information Risk

This type of financial intermediary can help reduce the asymmetric information risk by setting strong credit standards (such as requiring a high FICO score), performing extensive due diligence on the originators (to make sure their credit culture is strong), structuring repayments in ways that can improve performance (such as requiring that all loans be fully amortizing and that automatic ACH repayments are made, thereby eliminating the choice of which loans to pay off, as with credit card debt), and requiring the originator to buy back all loans that are shown to be fraudulent.

Additionally, they can enhance credit quality by requiring the use of social media to confirm information on the credit application. By improving transparency, they also facilitate the flow of capital to borrowers in a more efficient and dependable manner.

Riza Emekter, Yanbin Tu, Benjamas Jirasakuldech and Min Lu contribute to the literature with their 2015 study, “Evaluating Credit Risk and Loan Performance in Online Peer-to-Peer (P2P) Lending,” which appears in Applied Economics. They analyzed the data from the Lending Club, one of the largest providers of peer-to-peer loans. The database consisted of more than 61,000 loans, totaling more than $700 million, originated by the Lending Club in the period May 2007 to June 2012. Almost 70% of loans requested were related to credit card debt or debt consolidation. The next leading purpose for borrowing was to pay home mortgage debt or to remodel a home.

Key Findings

Following is a summary of the authors’ findings:

Borrowers with a high FICO score, high credit grade, low revolving line utilization, low debt-to-income ratio and who own a home are associated with low default risk. This finding was consistent with that reached by the authors of a study, “Trust and Credit: The Role of Appearance in Peer-to-Peer Lending,” which appeared in the August 2012 issue of The Review of Financial Studies.

It’s important to screen out borrowers with low FICO scores, high revolving line utilization and high debt-to-income ratios, and to attract the highest-FICO-score borrowers in order to significantly reduce default risk. The higher interest rate charged for the riskier borrower is not significant enough to justify the higher default probability.

The authors found that in the case of the Lending Club, the majority of borrowers (82%) had FICO scores between 660 and 749 (a score below 650 is considered low, a score between 650 and 750 is medium and above 750 is high) compared with 28% of the U.S. national average. About 80% of Lending Club borrowers fell into medium FICO score range, and they eliminate the one-third of borrowers who make up the riskiest population.

Diversification Benefits

Note that the authors’ findings on credit risk are consistent with those of Zhiyong Li, Xiao Yao, Qing Wen and Wei Yang, authors of the March 2016 study “Prepayment and Default of Consumer Loans in Online Lending.” They too found that default can be accurately predicted by a range of variables. The authors noted that there is increased prepayment risk on these loans, because the lenders don’t charge any early prepayment penalties.

However, if the lender requires that all loans be fully amortizing, and none are long-term (typically three- to five-year maturity), duration risk is relatively small. And, of course, loans that prepay have eliminated the risk of a later default.

In addition to relatively higher yields with relatively short durations, these loans also provide some diversification benefits. The reason is that their correlation with the equity markets tends to be low, except during periods of economic distress (such as the global financial crisis of 2008) when unemployment rises.

For example, over the first two months of 2016, equity markets experienced significant losses. However, there was no downturn in the economy that would have caused consumer defaults to rise. Investors saw the same thing following the “Brexit” vote in June.

Dampening Portfolio Volatility

In both cases, while equity markets were falling, the performance of these loans was unaffected. Thus, there are times—though not all times—when an investment in these loans will help to dampen portfolio volatility.

In addition, there are benefits to buying a portfolio of consumer loans that is diversified by geography (by states and even countries) as well as by profession/industry. For example, the ability of a dentist in London to pay back a loan versus a retailer in New York is likely to have a low correlation. Even within the U.S., states each possess a microeconomy that doesn’t necessarily move in tandem with others (for example, the recent oil price declines only impacted a few areas).

It is important to understand that consumer credit is somewhat different than corporate credit. There are examples of recessions that affected corporate balance sheets while consumer credit performed relatively well (with 2001 being a recent example).

Two Other Considerations

We have two other issues to consider. The first issue is asset location. Given that all the income from these investments will be ordinary, and taxed at the highest rates, investors should prefer to hold this asset in tax-advantaged accounts.

The second issue involves what should be the main role of fixed income in a portfolio: dampening the risk of the overall portfolio to acceptable levels.

While, on average, the correlation of this asset to stock risk is low, the correlation will still rise sharply during economic downturns as credit losses increase. Thus, unless an investor has a very low equity allocation, and also has both the ability and willingness to accept more risk, the allocation to this asset should be taken from the portfolio’s equity portion.

Until now, most investors have not had direct access to the consumer and small business credit risk premium. Today with the proper controls in place, investing in consumer direct loans can offer an attractive complement to a fixed-income portfolio. While they do entail incremental credit risk, they also currently provide sufficiently high yields to allow for high expected returns (after expected default losses) relative to other alternative investment strategies and they reduce the need to take duration risk, trading off to a degree one risk for the other in the portfolio.

My position that these assets could be worthy of consideration may seem contrary to my longstanding recommendation that one should limit fixed income to the safest investments (such as Treasurys, government agencies, FDIC-insured CDs and municipals rated AAA/AA that are also general obligation or essential service revenue bonds).

Corporate Risk Gone Unrewarded

The reason for that recommendation is that the research shows corporate credit risk has not gone well rewarded, especially after considering fund expenses. In this case, however, while these assets are not of the same quality as the aforementioned safe bonds, the evidence shows that investors have been well rewarded.

Until recently, the general public had no access to these investments. They instead resided on the balance sheets of banks and other lenders. Fintech firms seem to have disrupted that model, and investment management firms have now provided access to investors.

That said, due to the credit risk of these assets, investors should be sure to perform strong due diligence on any provider to ensure they are delivering access to only the higher-quality loans in this category, that they have a strong team in place performing a high level of due diligence in determining which originators they will buy assets from, and then that they persistently monitor loan quality.

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.